Over the past year, interest rates have continued to creep up putting the Fed between a rock and a hard place. How this shapes your investment portfolio is a key question. Inflation has been higher than the Fed's 2% target for more than five years. At first this was due to pandemic-induced disruption followed by global supply chain issues as the economy recovered from it. More recently, the ongoing disruptions to oil, natural gas, and agricultural supplies caused by the ongoing war between Ukraine and Russia have been exasperated by the conflict between the US and Iran that has effectively shutdown the Strait of Hormuz. At this point, this isn't news to any casual observer.
But structural issues are popping up all over that point to higher inflation for longer. With that, the expectation by many (including me) is for higher interest rates for longer as well. US trade policy has doubled-down on tariffs raising average rates from the 2% range for most of the decade to closer to 11%-13% range now. Increasing government deficits have bond investors "concerned" to say the least. Recent policy shifts announced by the US Treasury indicating more short-term bond issuance to refinance our growing debt will likely lead to higher long-term rate expectations. AI capital expenditures continue to dominate. And in the near term, this will likely continue to put pressure on prices throughout the economy as demand for advanced chips outstrips supply. Construction of data centers continues to put pressure on all sorts of trades and building materials.
To me, all this leads to higher inflation expectations which eventually leads to higher inflation. This will manifest itself in higher interest rates. And this, in turn, will have an impact on other sectors. Higher borrowing costs will put pressure on smaller companies though right now loans and working capital are still available and companies continue to be able to cash flow the higher debt service. Higher borrowing costs will hamper residential lending - more so on the refinance side of things but certainly making it less affordable for those trying to buy.
So, what's an investor to do? What we always do: Prepare for all weather conditions. Hedging by maintaining a reasonable allocation to alternatives like gold and commodities as well as inflation-linked corporate and government bonds will continue to be recommended by me. In addition to broad bond index holdings, private credit may still make sense since most of this type of debt is structured to reset to higher rates with inflation. As an alternative to traditional bond income or dividend-based stock holdings, the use of more options-based strategies tied to equity positions can also generate an alternative means to increasing income.
As for real estate, this sector has generally performed on par with or better than the S&P 500 this year depending on the sub-sector and geography. REITS, in general, have actually outperformed both the S&P and NASDAQ indices year-to-date. So, continuing to hold a meaningful allocation to real estate (more than 4%, in my opinion), just makes sense. As noted in the analysis below, "The key focus for investors should be less about the direction of rates and more on identifying the property types, markets, and vehicles capable of generating durable cash flow growth." The YTD chart included here is evidence of this. Positions in self-storage, specialty manufacturing facilities, data centers, healthcare and shopping centers have topped the list. Even office and lodging/hospitality have performed well compared to other sub-sectors of real estate like apartments and cell towers.
While a 10-year Treasury at 5% is psychologically tough and will make it more important to see if projects cash flow even in a higher rate world, there are clearly still opportunities available. Let's not throw the baby out with the bath water even if were feeling a little dizzy from news events and inflationary effects.
